California and AI IPOs: The Tax Mirage of Startups

California's Tax Dream

California, home to Silicon Valley, has been the primary beneficiary of big tech IPOs for decades. When Facebook went public in 2012, the state collected over $2 billion in capital gains taxes from employees who sold their shares. Now, with SpaceX valued at $2.5 trillion, and OpenAI and Anthropic — each with valuations near $1 trillion — preparing to go public this year, California anticipated the biggest tax windfall in its history.

However, as The Next Web notes in a recent analysis, reality could be quite different. Modern compensation structures have evolved, and with them, the way employee gains are taxed.

The Shift in Compensation: From ISO to RSU

Traditionally, startups granted stock options (incentive stock options, ISOs) that allowed employees to buy shares at a fixed price (the exercise price) and then sell them at the IPO, generating a gain subject to capital gains tax. But many AI companies have opted for restricted stock units (RSUs) or options with very low exercise prices, which reduces the tax base.

With RSUs, the employee receives shares directly at no cost, but the full value of those shares is considered ordinary income at the time of vesting, not capital gains. This means the employee pays income tax (at higher rates) rather than capital gains tax (at lower rates). Additionally, California taxes ordinary income at up to 13.3%, while long-term capital gains are taxed at the same rate, but the key difference is that RSUs do not generate a large capital gain at the time of sale; instead, income tax was already paid upon receiving the shares.

The result: the state could collect much less than expected, as employees of these companies may not have large capital gains to report. For example, if an employee receives RSUs worth $1 million, they pay income tax on that $1 million (approximately $130,000 for California), but if they had received options and exercised them for a $1 million gain, they would have paid the same capital gains tax (also $130,000). The difference is that with RSUs, the tax is paid earlier, and there is no subsequent sale that generates a spike in tax revenue for the state. Moreover, if the employee sells the shares immediately, the capital gain is minimal or zero.

The SpaceX Case: A Paradigmatic Example

SpaceX, with its $2.5 trillion valuation, could be the largest potential contributor. However, the company has been known for offering employees stock options with very low exercise prices, generating enormous capital gains. But even here, the timing of the sale and tax planning strategies can defer the impact. Many employees opt to sell on the secondary market before the IPO, which has already generated tax revenue, but not on the scale of a single massive IPO.

Implications for State Coffers

California faces a significant budget deficit, and the promise of a 'windfall' from AI IPOs was a hope to close gaps. If collections are lower, the state may have to cut services or raise taxes. Additionally, this could influence other startups' decisions on where to locate: if California does not offer the expected tax benefit, companies might consider other states with lower taxes.

What Should Readers Know?

Investors and startup employees should understand that compensation structure directly impacts their personal tax burden. For market observers, the lesson is that traditional metrics of 'IPO tax impact' may be outdated. Tax authorities should also review their projections and consider how new compensation forms alter revenue flows.

In summary, the expected tax 'boom' from AI IPOs in California may be more of a mirage than reality. Modern compensation structures, such as RSUs and low-price options, reduce the capital gains tax base, leaving the state with less revenue than anticipated. This has implications not only for California but for any jurisdiction that relies on capital gains taxes from tech companies.